S.E.C. to Ease Auditing Standards for Small Publicly Held Companies

By STEPHEN LABATON

Published: December 11, 2006

The Securities and Exchange Commission will begin the process of easing auditing standards for thousands of smaller public companies this Wednesday when it proposes rules under the most contentious provision of the Sarbanes-Oxley Act.

The relaxed standards represent a compromise, giving a qualified victory for businesses, which had considered any regulation burdensome, and for the auditing firms, which had benefited from the imposition of stringent requirements on their clients.

Section 404 of the act requires publicly traded companies to assess the controls they have put in place to ensure that their financial reports are reliable. The rule, a response to the many accounting frauds that haunted investors before the legislation, was intended to try to discourage fraud and manipulation of financial statements.

But Congress left it to the regulators to determine precisely how thoroughly auditors had to examine financial controls, and the commission has repeatedly delayed imposing any rules on smaller companies until it considered their complaints and worked out details -- a temporary exemption that benefited about four out of five of all public companies.

The commission's long-awaited interpretation of Section 404 is the culmination of a fierce lobbying battle. It has pitted the largest accounting firms, which have reaped huge profits from the tighter standards, against an equally influential coalition of small public companies, which has lobbied for years for relief.

The proposal will, for the first time, impose a ''materiality standard'' -- that is, auditors will be advised to scrutinize only those controls that could have a reasonable risk of having a material impact on the financial statements. It is expected to encourage auditors to rely on prior years' work as a basis for testing controls and discourage auditors from multiple testing of the same controls. And it will encourage the auditors to use a ''risk assessment'' to focus the audit on the areas of greatest potential concern.

Commission officials said last week that the proposal would not be an unequivocal victory for smaller companies because it would not give them what they wanted most: a blanket exemption from Section 404. Nor would it impose a sharp restriction that would limit the auditors to looking at the design of the financial controls.

But the officials said the proposal would address many of the cost concerns raised by small businesses.

''It will squeeze out all the unnecessary cost,'' said a senior official who was central in drafting the rule and spoke on the condition of not being identified. ''What we really wanted was something that both tastes great and is less filling.''

The commission's action is being coordinated with the Public Company Accounting Oversight Board, a sister agency that will be issuing the proposed new auditing standard under the same provision next week. The new standard will fill in many of the vital details for the companies and their accountants.

The fight over auditing standards has far broader political implications, according to officials, lawmakers and industry executives. An adequate resolution of the issue by regulators would take significant pressure off Congress to address other complaints from some business groups about the law and other corporate governance rules.

Since the Sarbanes-Oxley law was adopted, small businesses have maintained that it imposed unnecessary costs and burdens. The accounting firms, which have experienced a sharp increase in their billable hours as a result of the law, have praised the provisions, while groups representing institutional investors have sought to prevent the regulators from watering down the provision in ways that could lead to more accounting abuses.

''Sarbanes-Oxley was fundamentally about a whole series of measures designed to make sure that the numbers that corporations put out are basically true,'' said Damon A. Silvers, who closely follows corporate governance issues as an associate general counsel at the labor union federation A.F.L.-C.I.O. ''The debate over Section 404 has been critical to ensuring that purpose in two respects: first, no one should be able to sell securities that do not have adequate internal controls, and second, whether the system of oversight over the auditing industry was going to work. It feels today as though we may be getting both of those things right.''

Some large companies have also complained about the increased audit costs, but new data suggests that the law is having beneficial effects for investors. A new study by Glass, Lewis & Company to be released this week shows that although financial restatements of public companies increased by 12 percent in 2006, they have actually declined by 25 percent among large companies. The study attributes the decline among large companies to the effects of Section 404.

In recent weeks, federal regulators have described the overall framework for the new rules. They have been drafting what they call a ''scaled standard'' that they say will be flexible to the needs and characteristics of each company. A small company with complicated financial issues, like one heavily involved in derivative securities, for instance, might face more rigorous auditing of its controls than one of similar size with fewer accounting issues. Similarly, a large but relatively uncomplicated company might face a less rigorous auditing than comparably sized companies.

The rule making follows weeks of behind-the-scenes negotiations between the commission and the Public Company Accounting Oversight Board. Some officials involved in that process said that the oversight board, largely agreeing with the position of the accounting firms that it regulates, had beaten back attempts by some on the commission to loosen the standard even further.

A central issue concerned the reach of the audit of controls. In a letter on Nov. 6 to Mark W. Olson, the chairman of the accounting board, Christopher Cox, the chairman of the Securities and Exchange Commission, said that the focus of the audit should be on ''the suitability of the design of internal controls.''

The major auditing firms, as well as some investor groups, privately complained to the commission that that standard was too narrow and would send the wrong signal to companies. In response, the S.E.C. appears to have yielded and will propose a broader approach on Wednesday, officials said.

Federal regulators say they have struggled to balance the interests of investors against the unnecessary burdens on small companies.

''The Sarbanes-Oxley Act's internal control requirements have been described as the most significant change in public company auditing since the advent of the federal securities laws,'' Mr. Olson said in a statement issued by the agency last week. ''While the requirements provide great benefits to companies and their investors, we are concerned that the costs are not adequately aligned with the benefits.''

The resolution of the debate over Section 404 has broad political consequences. The two new Democratic chairmen of the House and Senate committees that oversee the markets--Representative Barney Frank of Massachusetts and Senator Christopher Dodd of Connecticut -- have both said in recent days that they will be watching the situation closely.

Some lawmakers have called for Congress to reopen the Sarbanes-Oxley law and water down what they see as its more onerous provisions. Treasury Secretary Henry M. Paulson Jr. has also said he believed that the regulators could resolve the complaints about Section 404 without any need forCongressional intervention.

Photos: Christopher Cox of the S.E.C. said audits should focus on ''the suitability of the design of internal controls.'' (Photo by Lawrence Jackson/Associated Press)(pg. C1); Mark W. Olson, chairman of the accounting oversight board. (Photo by Dennis Brack/Bloomberg News)(pg. C2)